Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc.

, 2008
Managerial Economics &
Business Strategy
Chapter 1
The Fundamentals of Managerial
Economics
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Overview
I. Introduction
II. The Economics of Effective Management
Identify Goals and Constraints
Recognize the Role of Profits
Five Forces Model
Understand Incentives
Understand Markets
Recognize the Time Value of Money
Use Marginal Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Managerial Economics
Manager
A person who directs resources to achieve a stated goal.
Economics
The science of making decisions in the presence of
scare resources.
Managerial Economics
The study of how to direct scarce resources in the way
that most efficiently achieves a managerial goal.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Identify Goals and Constraints
Sound decision making involves having
well-defined goals.
Leads to making the right decisions.
In striking to achieve a goal, we often face
constraints.
Constraints are an artifact of scarcity.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Economic vs. Accounting
Profits
Accounting Profits
Total revenue (sales) minus dollar cost of producing
goods or services.
Reported on the firms income statement.
Economic Profits
Total revenue minus total opportunity cost.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Opportunity Cost
Accounting Costs
The explicit costs of the resources needed to produce
produce goods or services.
Reported on the firms income statement.
Opportunity Cost
The cost of the explicit and implicit resources that are
foregone when a decision is made.
Economic Profits
Total revenue minus total opportunity cost.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Profits as a Signal
Profits signal to resource holders where
resources are most highly valued by society.
Resources will flow into industries that are most highly
valued by society.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Sustainable
Industry
Profits
Power of
Input Suppliers
Supplier Concentration
Price/Productivity of
Alternative Inputs
Relationship-Specific
Investments
Supplier Switching Costs
Government Restraints
Power of
Buyers
Buyer Concentration
Price/Value of Substitute
Products or Services
Relationship-Specific
Investments
Customer Switching Costs
Government Restraints
Entry
Entry Costs
Speed of Adjustment
Sunk Costs
Economies of Scale
Network Effects
Reputation
Switching Costs
Government Restraints
Substitutes & Complements
Price/Value of Surrogate Products
or Services
Price/Value of Complementary
Products or Services
Network Effects
Government
Restraints
Industry Rivalry
Switching Costs
Timing of Decisions
Information
Government Restraints
Concentration
Price, Quantity, Quality, or
Service Competition
Degree of Differentiation
The Five Forces Framework
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Understanding Firms Incentives
Incentives play an important role within the firm.
Incentives determine:
How resources are utilized.
How hard individuals work.
Managers must understand the role incentives play
in the organization.
Constructing proper incentives will enhance
productivity and profitability.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Market Interactions
Consumer-Producer Rivalry
Consumers attempt to locate low prices, while producers
attempt to charge high prices.
Consumer-Consumer Rivalry
Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those goods.
Producer-Producer Rivalry
Scarcity of consumers causes producers to compete with
one another for the right to service customers.
The Role of Government
Disciplines the market process.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
The Time Value of Money
Present value (PV) of a future value (FV) lump-
sum amount to be received at the end of n
periods in the future when the per-period interest
rate is i:
( )
PV
FV
i
n
=
+ 1
Examples:
Lotto winner choosing between a single lump-sum payout of $104
million or $198 million over 25 years.
Determining damages in a patent infringement case.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Present Value vs. Future Value
The present value (PV) reflects the
difference between the future value and the
opportunity cost of waiting (OCW).
Succinctly,
PV = FV OCW
If i = 0, note PV = FV.
As i increases, the higher is the OCW and
the lower the PV.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Present Value of a Series
Present value of a stream of future amounts (FV
t
)
received at the end of each period for n periods:
Equivalently,
( ) ( ) ( )
PV
FV
i
FV
i
FV
i
n
n
=
+
+
+
+ +
+
1
1
2
2
1 1 1
...
( )

=
+
=
n
t
t
t
i
FV
PV
1
1
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Net Present Value
Suppose a manager can purchase a stream of future
receipts (FV
t
) by spending C
0
dollars today. The
NPV of such a decision is
( ) ( ) ( )
NPV
FV
i
FV
i
FV
i
C
n
n
=
+
+
+
+ +
+

1
1
2
2 0
1 1 1
...
Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Present Value of a Perpetuity
An asset that perpetually generates a stream of cash flows
(CF
i
) at the end of each period is called a perpetuity.
The present value (PV) of a perpetuity of cash flows paying
the same amount (CF = CF
1
= CF
2
= ) at the end of each
period is
( )
( ) ( )
i
CF
i
CF
i
CF
i
CF
PV
Perpetuity
=
+
+
+
+
+
+
= ...
1 1
1
3 2
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Firm Valuation and Profit
Maximization
The value of a firm equals the present value of
current and future profits (cash flows).
A common assumption among economist is that it is
the firms goal to maximization profits.
This means the present value of current and future profits, so the firm
is maximizing its value.
( ) ( )
( )

=
+
= +
+
+
+
+ =
1
2 1
0
1
...
1 1
t
t
t
Firm
i
i i
PV

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Firm Valuation With Profit
Growth
If profits grow at a constant rate (g < i) and current
period profits are
,
before and after dividends are:
Provided that g < i.
That is, the growth rate in profits is less than the interest rate and
both remain constant.
0
0
1
before current profits have been paid out as dividends;
1
immediately after current profits are paid out as dividends.
Firm
Ex Dividend
Firm
i
PV
i g
g
PV
i g

+
=

+
=

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Control Variable Examples:
Output
Price
Product Quality
Advertising
R&D
Basic Managerial Question: How much of
the control variable should be used to
maximize net benefits?
Marginal (Incremental)
Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Net Benefits
Net Benefits = Total Benefits - Total Costs
Profits = Revenue - Costs
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Marginal Benefit (MB)
Change in total benefits arising from a change
in the control variable, Q:
Slope (calculus derivative) of the total benefit
curve.
Q
B
MB

=
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Marginal Cost (MC)
Change in total costs arising from a change in
the control variable, Q:
Slope (calculus derivative) of the total cost
curve
Q
C
MC

=
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Marginal Principle
To maximize net benefits, the managerial
control variable should be increased up to
the point where MB = MC.
MB > MC means the last unit of the control
variable increased benefits more than it
increased costs.
MB < MC means the last unit of the control
variable increased costs more than it
increased benefits.
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
The Geometry of Optimization:
Total Benefit and Cost
Q
Total Benefits
& Total Costs
Benefits
Costs
Q*
B
C
Slope = MC
Slope =MB
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
The Geometry of Optimization:
Net Benefits
Q
Net Benefits
Maximum net benefits
Q*
Slope = MNB
Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008
Conclusion
Make sure you include all costs and benefits
when making decisions (opportunity cost).
When decisions span time, make sure you
are comparing apples to apples (PV
analysis).
Optimal economic decisions are made at the
margin (marginal analysis).